Thursday, May 28, 2015

More on currency crises and the euro crisis

I wrote a while ago about currency crises (see here). There I suggested that classical-Keynesian or post-Keynesian views on currency crises invert the causality between fiscal and balance of payments problems in a currency crisis. Currency crises are not caused by excessive fiscal spending financed by monetary emissions, which would lead to inflation, and eventually after a run on the currency and depletion of reserves to a devaluation, but on current account problems.

There two key problems with the conventional view. On the one hand, the very monetarist notion that increases in money supply have direct impact on prices, and no effect on quantities. That would be an extreme natural rate hypothesis. But also that these models presume that fiscal deficits and debt denominated in domestic currency are the problem in currency crises, when the relevant debt is the foreign one, related to the current account deficit, and denominated in foreign currency. In other words, whereas default in the former is not possible, in the latter it clearly is. The mismatch between government receipts in domestic currency and foreign debt obligations in foreign currency is the key problem in currency crises.

Fiscal deficits might play a role in a currency crisis, but it is ultimately an indirect one. If the fiscal deficit, by leading to an increase in the level of activity (not prices) leads to a current account deficit, then it does exacerbate the external constraint of the economy, and might contribute to the eventual depreciation. Note that this suggests that the variations of the level of income are more relevant for the adjustment of the balance of payments, than changes in the exchange rate, something noted for the case of peripheral economies, in particular Argentina during the Gold Standard, by A. G. Ford (for a discussion of that go here).

In a classical-Keynesian view the fiscal crisis might be a result of the currency crisis, and not vice versa (as I discussed for Brazil here). If the crisis leads to a recession, then fiscal revenues collapse, and spending increases, particularly unemployment insurance expenditures, welfare spending, and transfers, exacerbating the fiscal problems. Further, the central bank might hike the domestic interest rate, to preclude capital flight and further devaluation and that would have an additional effect on interest payments on domestic debt, also worsening the fiscal stance.

This currency crisis story might have some relation to the current debate between Marc Lavoie and Sergio Cesaratto on whether the European crisis should be seen as a a monetary sovereignty problem (Marc) or balance of payments crisis (Sergio). Both would agree that the crisis is not the result of fiscal problems, as described above. Even in Greece, that had higher fiscal deficits than others, the relevance of those deficits, and the enforcing of brutal austerity afterwards, has been associated to the current account. Note that in common currency areas, like the United States, federal fiscal transfers (and not just inter-state transfers) would allow for imbalances to continue without leading to contraction of output to reduce the regional balance of payments constraints, as noted by Nate Cline and David Fields here.

Alternatively, in the absence of fiscal transfers from a federal European government, if the European Central Bank (ECB) had the ability to buy euro denominated bonds of peripheral countries and keep their borrowing costs low, fiscal policy could be used by member countries, without risk of default. That's what Marc Lavoie has argued, that at the heart of the problem there is a monetary sovereignty problem. Basically the ECB could transform what is effectively a foreign currency problem, since peripheral countries have a constraint in euros, into an essentially domestic problem with no risk of default. On the other hand, it is also true that the manifestation of the euro crisis is in the form of a regular balance of payments problem, as noted by Sergio Cesaratto. In a sense, both are correct. The imbalances in the current account, which Sergio puts at the center, become relevant because in the absence of fiscal transfers, and of a monetary authority providing a zero risk asset for governments to borrow in times of crisis, as emphasized by Marc, the adjustment is done by variations of the level of income.

The difference might lie not so much in the diagnostic, which is basically the same (they also agree on Keynesian fashion that the current account adjustment is done by variations in quantities not prices), but on the policy alternatives. Sergio's emphasis seems to suggest that exit is the best alternative. Marc's views would indicate that reforming the institutions would be better (mind you, they might think differently, I'm suggesting what the different emphasis might imply). It is unclear to me that depreciation and exit from the euro would solve the problems of peripheral countries (on the role of depreciation on solving the external problem in Greece, that is, Greexit, go here). On the other hand, the reform of the European institutional framework has proceeded at pace that seems too slow for the magnitude of the problems faced in the peripheral countries. There is no good alternative.

PS: The Troika's solution is austerity, since the the crisis is seen as a fiscal problem, as in conventional currency crises models. And the ECB should in that framework remain concerned only with inflation.